Boosting Savings and Raising Returns
An Institutional Investor Sponsored Report on Retirement Security
Retirement plan participants face challenges from a low-expected-return environment made worse by too-low saving rates. Plan sponsors are responding with new investing strategies and plan design innovations.
By Howard Moore
Lousy returns. For retirement plan participants, they are the 300-pound gorilla in the room — the one that, somehow, is easy to miss.
“The most important issue facing retirement security is the low-expected-return environment, which is far too often overlooked,” says Antti Ilmanen, principal and head of the portfolio solutions group at AQR. When defined-contribution-plan participants calculate the saving level they need to hit to assure themselves a comfortable retirement, it highlights the need for them to save more. But these calculations assume investors will achieve the same returns they have experienced over the past 30 or 40 years.
“We think that’s incredibly optimistic,” Ilmanen says. Factoring in an expected return just a couple of percentage points lower on an investor’s future portfolio approximately doubles the required saving rate over the course of that individual’s career. “This generation of savers is going to have a more difficult time achieving the needed savings to afford a comfortable retirement,” concludes Ilmanen.
Coupled with the other risks that plan participants face, including longevity, inflation and taxes (see “Five key risks,”), low expected returns are prompting more U.S. plan sponsors to take a multipronged, holistic approach to financial wellness, with some companies even making services available to help individuals budget, manage debt and navigate different life stages. “When an employee has a child, for example, more employers offer help to prioritize savings between education, health and retirement,” says Rob Austin, director of retirement research at Aon Hewitt.
The aim is to make employees more aware of their finances in general and their short- and long-term financial needs in particular. “Over the past ten years, more people have come to rely solely on their 401(k) plans and many have not changed their savings behavior very much,” Austin says. Many believe they cannot afford to save. “The conversation is shifting to financial wellness in general in order to solve the problem of low participation, not just the symptom.”
DC plans have largely replaced traditional defined benefit pension plans in the U.S., placing the weight of responsibility to save for retirement on employees. “That’s okay in the accumulation phase, but the problem comes when you start to live off of what you saved,” says Graham Day, national sales manager at AXA Distributors. For retirees with a classic 60/40 portfolio, the general rule of thumb has been to withdraw 4 percent per year. This has come into question in the past few years, however, as periods of extreme equity market volatility have eroded assets and disrupted retirement income planning. Low interest rates, meanwhile, have pushed fixed income well below its historical yields of 3 to 4 percent. “Withdrawal rates now should be 2.75 to 3.25 percent, which completely reshapes portfolio construction and retirement income planning,” Day says.
So how best to invest? Equities provide a premium over bonds, but they are hitting historically high valuations and therefore offer lower expected returns. “Plus, investor portfolios are already dominated by equity risk,” says Ilmanen.
Other possibilities are alternative asset classes such as hedge funds, private equity or real assets. “If you can invest in them at fair fees, they are part of the answer,” Ilmanen notes. Liquid alternative strategies offering better risk diversification — including risk parity and style, or factor, strategies such as value and momentum investing — have become available in recent years. “These are increasingly popular ways for investors to reduce equity concentration by using return enhancers,” Ilmanen says.
Defensive approaches such as low-volatility and trend-following strategies have done well historically in difficult markets, Ilmanen points out. “We like strategies that diversify well, reduce risk and provide positive returns over the long run — a good combination to have as a core component within a portfolio and especially helpful when markets go sideways,” he says.
national sales manager,
principal and head of the portfolio solutions group, AQR
|“Volatility often turns|
people who are normally
investors into savers.
They react emotionally and
begin to deviate from their
investment program at the
|“Equities provide a premium over bonds, but they are hitting historically high valuations and therefore offer lower expected returns. Plus, investor portfolios are already dominated by equity risk.”|
Many alternative and some long-short strategies that use leverage are popular in the DB world but have not caught on with DC plans. “Certain long-only portfolios that use style or factor tilts are playing a growing role in U.S. DC plans, but many liquid alternative strategies are still underutilized,” says Ilmanen. Trend following, for example, is a DB plan strategy that has been a surprisingly good performer in bear markets like 2008–’09. “There are not many investments that can do this, and when DB plans came to understand the empirical characteristics and behavior of these strategies, they began to take notice,” Ilmanen says. “We view this as an opportunity for DC plans.”
Risk parity is another promising strategy, especially within target date funds (TDFs). The classic TDF starts with 90 percent equities and follows a glide path to 50 percent at retirement. “Even though a 50 percent equity allocation sounds diversified, equities still represent 90 percent of total portfolio risk, which is a pretty dangerous portfolio for someone at retirement,” says Ilmanen. Applying the principles of risk diversification and holding a more explicitly risk-balanced portfolio through life could be a better option.
A further concern in a low-expected-return environment is the fact that, as the workforce ages, more plan participants are approaching retirement. “Now investors are looking for ways to protect their portfolios,” says Day. Many are doing so with life insurance and annuities. Whether fixed or variable, annuities provide a level of assurance of a lifetime of income even if the market takes a slide, the individual happens to retire at the wrong time or a prolonged period of low interest rates dents their fixed-income holdings. Annuities “are almost like a personal defined benefit plan,” Day says. They have evolved as investors’ needs have evolved, with fixed, variable, hybrid, pure indexed and other types available to meet a variety of risk and return preferences.
Participation and design
If plan participants are to explore less conventional approaches in response to a low-expected-return landscape, including alternative investments and target date funds, staying the course when markets get scary becomes all the more important. In the ten years since it was sanctioned under the Pension Protection Act, automatic enrollment has become close to a standard DC plan feature and plan sponsors have made further innovations to encourage employees to join the plan and stick with it.
“Auto-enrollment programs began at about 3 percent of gross income, and many employees enrolled at that level and stayed there, which isn’t high enough to ensure a comfortable retirement,” says Austin. Today employers are setting default rates higher and adding auto-escalation. “Last year we saw for the first time that the majority of plans auto-enroll employees at a rate that’s at or above the threshold at which they provide matching contributions,” Austin notes.
TDFs are becoming the norm as the default option under auto-enrollment. “Forty cents of each new dollar contributed to a 401(k) plan goes into a target date fund, and they are rapidly becoming the largest asset class for many plans,” says Austin. Because TDFs are large and growing, he foresees a lot of evolution and innovation: active versus passive, custom designed or off the shelf.
By no means are all plan participants using TDFs as intended, however. While they were designed to be an all-in investment, only 55 percent of plan participants with TDFs use them as their principal retirement investment vehicle, according to Aon Hewitt research. “We find that plan participants may allocate 50 percent of their assets to a target date fund, 25 percent in a large-cap equity fund and the remaining 25 percent into company stock, for example, which has far more risk,” Austin says.
To help them make the best use of TDFs, or of any of their investment options, plan sponsors must understand participants’ investment preferences and their motivations and concerns as they make investment elections. “We’re finding out if people simply don’t understand target date funds or if they are looking for something more aggressive,” Austin says.
These issues aside, alternative investments, TDFs, annuities and plan features like auto-enrollment help make DC plans a more viable vehicle for participants to achieve retirement security in a low-expected-return environment.
“DC plans have historically tended to underperform DB plans, due to their holding less diversified portfolios and other inefficiencies,” says Ilmanen. Many investors and plan sponsors still believe the only way to improve returns is by taking more risk through equities, but there is growing recognition that DC plans can enhance performance by adopting some of the less conventional solutions.
“I’m optimistic that there can be a change in approach,” Ilmanen says — a shift the pension industry should prepare itself for as investor concerns mount about persistent low returns. “In the short term a solution may be to tweak equity-oriented portfolios with style tilts and better risk balancing via risk parity, but long term I expect more openness for even more innovative solutions.”
|Five Key Risks|
Retirees and people planning for retirement face five key risks, says AXA Distributors’ Graham Day. Topping the list is longevity risk. With more people living more years, the distribution phase — when they will be taking money out of their savings instead of accumulating it — looms large. A close second is inflation and the need to factor in the shifting purchasing power of the dollar in ten, 15 or 20 years. “People have to account not only for the rising cost of living for the 30 or 35 years they will be in retirement, but for the exponentially rising critical costs, like health care and prescription drugs,” Day says. Many financial planners do not allow for a sufficient rise in inflation when creating a retirement income plan. The third key risk is volatility, which markets appear to be exhibiting with greater frequency. “Volatility often turns people who are normally investors into savers,” says Day. “They react emotionally and begin to deviate from their investment program at the wrong time.” This underscores the need to craft a sound investment plan and stick to it.
Interest rate risk also looms large. “We’re in a historically low-interest-rate environment, with the ten-year Treasury hovering around 1.5 percent, which is unprecedented,” Day notes. Over the past 50 years, the ten-year Treasury has averaged 5 percent more than 90 percent of the time. “It’s great if you’re refinancing a home, but it’s unfortunate if you’re looking for a strong fixed rate of return.” When rates do start to rise, savers and other investors with much of their holdings in fixed income will see the value of these investments drop. “That’s a major concern, especially as those who are further into retirement reallocate from equities to fixed income,” Day says.
The last of the five key risks is taxes, which have been historically low for some years but increased for capital gains and qualified dividends in 2013. “It’s a major issue for high-income earners and those who have trust assets as well as those who have investments outside of IRA and other tax-deferred retirement accounts,” Day says. Active mutual funds are no longer able to write off losses from 2008–’09 and 2010. “There have been significant accumulated gains and thus distributions, and if they’re owned outside of an IRA or other retirement plan, they are taxed on the way up, the way down and the way out,” he warns. —H.M.